Originally published on Forbes.com Aug 14th, 2013
You cannot tell from the recent decision of California State Board of Equalization why Analytical Environmental Services was formed as a California C corporation in 2001. Whatever the reason, there was either a change in circumstances or the owners changed their minds, because AES elected S status effective January 1, 2005. Apparently paying California $115,013 in Built-In Gains tax was not part of the plan, but that is the way it is working out.
What Is The Built In Gains Tax ?
California’s built-in gains tax closely follows the federal provision. In the good old days, you could liquidate a corporation without recognizing gain at the corporate level. The concept was called the General Utilities doctrine in honor of a 1935 Supreme Court decision. General Utilities became a doughty old soldier, but he was a casualty of the Tax Reform Act of 1986. Somebody figured out that you could achieve a similar result by making an S election before you liquidated. So the BIG tax was implemented to drive a stake through the General’s heart.
The BIG tax requires you to compute the net built in gain inherent in corporate assets and liabilities that have not been recognized for income tax purposes. For a considerable period after the S election any sort of disposition of assets held at the date of the election can give rise to recognition of some of that built-in gain.
Of course a particular asset might have a built-in loss, which could offset some of the built-in gain. Payment of certain liabilities can also make for built-in loss recognition. When I said “considerable period”, I was being deliberately vague. It was, and in some ways still is, 10 years, but there have been periodic openings to dispose of assets somewhat earlier than that without paying BIG. Whether it was 5 years or 10 years was not relevant to AES, which was a consulting company.
The Problem With Consulting Companies
My first managing partner, Herb Cohan, was pretty predictable. He ran Joseph B. Cohan and Associates based on two fundamental business principles. Money coming in is good. Money going out is bad. As you exited the office with your audit bag, if Herb asked you where you were going, you could be certain of his response to your answer “Bring back a check.”
When one of the partners suggested that we prepare accrual basis financial statements for the firm, he scoffed – “You’re kidding yourself.” At the end of the year we would zero out the corporate taxable income with salaries. It was a common practice for professional C corporations, still is for the few that are left, I would think.
AES was not quite as cavalier and did prepare accrual basis financial statements. They even used those to reflect the balance sheet on the tax return. When you think about realizing a built-in gain, you might think that that involves selling something. It can, but that is not the whole of it. The accounts receivable of a cash basis corporation represent an item of built-in gain. In the nature of things, the receivables will be mostly recognized in the subsequent year – otherwise they were not very good receivables.
That is what generated the BIG tax for AES. They had a pretty logical argument for there being a built-in loss to offset that built-in gain. When professional firms of all sorts collect their receivables, the proceeds, to a significant extent, go to pay salaries to the people whose efforts created the receivables. There were some problems with this theory:
On Schedule L of its 2005 California tax return, appellant indicated that, as of January 1, 2005, it had accounts receivable totaling $1,788,197 and accounts payable totaling $414,621. Appellant did not report any other payable or accrued expenses for salaries and/or bonuses as of January 1, 2005, on its Schedule L.
In short, the FTB asserted that, to be entitled to a reduction of its BIG tax liability, appellant would have to provide credible evidence (i.e., either books and records, contracts, board minutes, etc.) substantiating that (i) the bonuses appellant paid in 2005 became legal liabilities to appellant as of the date of the S election, and (ii) the exact amounts of the bonuses were established as of the date of the S election.
The Board simply did not see a built-in loss there:
Here, appellant has not provided credible evidence (e.g., either books and records, employment contracts, board minutes, etc.) to establish that as of the beginning of the recognition period (i.e., January 1, 2005) the bonus obligations existed and the amounts of those obligations were determined (or reasonably estimated). Thus, the bonus obligations cannot be included in appellant’s calculation of NUBIG.
Even though appellant argues that “the funds from which the bonuses were paid relate to the production of outstanding accounts receivable on the effective date of the S election,” it is possible that the bonuses were determined and awarded only after January 1, 2005 (as the FTB has alleged) and appellant has not shown otherwise. Based on our analysis of the foregoing factors, we find that the bonus amounts appellant paid in 2005 cannot be used to reduce appellant’s BIG tax liability for the 2005 tax year.
Practical Implications
The most obvious practical take-away from this case is that if you are going to organize your professional practice as a C corporation, you should have an awfully compelling reason for doing it that way. Assuming that you have gotten yourself in that pickle and want to get out with an S Election, the case more or less provides you with a blueprint for what you should do by mentioning all the things that AES did not do. Document the obligation of the company to pay out bonuses based on accrual income, make entries to reflect the obligation and pay them within two and a half months. Make the payments even if you may have to loan money back for working capital and, of course, be rigorous about executing notes if that is required.
You can follow me on twitter @peterreillycpa.
Aftenote
The only scenario I have been able to think of that might make it worthwhile to organize a professional practice as a C corporation is a sole practitioner who has the need to make very large out-of-pocket medical payments – a special school for a disabled child for example. That would make a medical reimbursement plan worthwhile. Does anybody have any other ideas ?
For those of a historical bent, the reason there were so many of them in the old days was mainly due to pension rules.
I asked a few blogging buddies if there is a good reason for making a practice a C corporation. Joe Kristan suggested that maybe if you hated your colleagues and were going to go off on your own, it would be a good plan. Watch this space and the comments section for other possible answers.